What To Do in a Falling Market

We ran an earlier version of this post on the Wealthfront blog in June 2013 after a turbulent run in the market. For many, it’s hard to remember that June 2013 was a volatile month given how great 2013 turned out to be by the end of the year. Given the recent market volatility in September 2014, we thought an update of this post with fresh data would be valuable to our readers.

The global equity markets have been increasingly turbulent over the past few weeks. The S&P 500 began September at over 2000, and proceeded to drop 2.9% through September to close at 1946.16 on October 1st. Small caps performed more poorly, with the Russell 2000 dropping 7.6% in the same time period. Emerging markets fared even worse, dropping 8.9% during the month.

As a result, it’s only natural that many investors are asking: “What should I do in a falling market?”

There are three rational actions to take in response to a falling market, actions that research shows will serve you well in the long run: Keep investing. Rebalance. Harvest your losses.

But investors are rarely rational. They’re human. When there is turbulence in the markets, people typically have one of three emotional responses:

You want to sell everything in an attempt to “limit” the loss.

We talked about this fear-based response to the market’s movements. If you’re feeling this fear now, you may be extrapolating the past few weeks of declines forward to the next few weeks or months. But no one can predict the market. Selling to limit your losses is merely market timing by another name – and trying to time the market is investors’ most serious mistake, as our CIO Burt Malkiel, wrote.

When individual investors try to time the market they are much more likely to buy and sell at the worst times. Emotionally, investors suffer great pain when pessimism is rampant and stock prices fall. They are more likely to buy when everyone is optimistic and prices are near or at their peak.Investors who try to time the market end up, on average, in the worst of both worlds: selling low and buying high. Independent research firm DALBAR found that this poor behavior costs the average investor on the order of 4% per year. (DALBAR, 2012)

You want to close your eyes and avoid looking at the numbers.

This isn’t a terrible response. Even during the biggest market collapse in recent history (2008-09), holding the same set of investments through the crash and rebound would have resulted in a return to previous levels, five years later. This chart tells the tale.

You want to be opportunistic and buy.

If you act rashly on this emotion, you may end up making a mistake, buying so much that you throw your asset allocation off (without a service that automatically invests you in the right proportion to your asset allocation). But it’s great to be comfortable acting in a non-conformist way as an investor — buying when everyone else is selling. Just apply some of the research and rational thinking that we’ll share below.

When Markets Fall, A Little Perspective Helps

First, a little perspective before you take any action. When the media shows you a chart, they are usually adjusting its scale to help their ratings. The chart this month for SPY, the leading S&P 500® ETF, looks a little scary:

The same month looks a lot better if you extend the chart’s scale to look at all of 2014.

It’s hard to complain about a year like that, isn’t it? Framing market returns tends to highlight the inevitable truth: Over long periods, equity markets are volatile, but they have inevitably generated significant returns above inflation. In fact, short term framing is almost always done, explicitly or implicitly to evoke an emotional, and often counter-productive, reaction from investors.

Don’t fall for it.

Three Things You Should Do in a Falling Market

If you want to take advantage of a market decline, the easiest thing to do is keep investing. If you are in the midst of a regular investment schedule, as many of our clients are, you can take advantage of the market’s dip through dollar-cost averaging, or regularly scheduled deposits. Automating your deposit schedule is the best way to ensure that you avoid roller coaster emotions and stick to your long term plan.

The other two ways to take advantage of the falling market are to rebalance and to tax-loss harvest.

Rebalancing your investments maintains your asset allocation – the allocation that is designed to help you meet your long-term goals. While many services rebalance only at fixed time periods – the end of the quarter or the end of the year, research shows that rebalancing based on deviation from your ideal portfolio, not time, yields better results. That’s because rebalancing is a form of forced contrarianism that takes advantage of reversion to the mean. It buys asset classes that have performed poorly relative to their peers and sells the best performers.

The result of rebalancing is lower volatility and, often, better returns over time. In their book Elements of Investing, noted investment experts Burt Malkiel and Charley Ellis found that from 1996 to 2005, rebalanced portfolios generated average annual returns of 8.46% vs. 8.08% for those that were never rebalanced. The rebalanced portfolios had less volatility (standard deviation of 9.28% vs. 10.05%) than the portfolios that were not rebalanced.

Tax-Loss Harvesting is a more sophisticated way to take advantage of volatility. By selling assets for a loss, you gain the opportunity to use that loss against other gains for the year on your annual taxes. A similar asset is purchased immediately so that you can participate in any market rebound. For larger accounts, harvesting the tax losses within an index, like the Wealthfront 500, can realize even more benefit in volatile markets.

The Wealthfront Approach

Wealthfront automatically rebalances and harvests tax losses based on thresholds established by our software and the type of account you hold with us. In fact, we have made over two hundred thousand rebalancing and harvesting trades within our clients’ portfolios in just the past five weeks. (Of course, there are no fees charged for trades at Wealthfront.)

At Wealthfront, we’ve built the optimal automatic service to help our clients make the most of turbulent markets:

About Adam Nash

Adam Nash, Wealthfront's CEO, is a proven advocate for development of products that go beyond utility to delight customers. Adam joined Wealthfront as COO after a stint at Greylock Partners as an Executive-in-Residence. Prior to Greylock, he was VP of Product Management at LinkedIn, where he built the teams responsible for core product, user experience, platform and mobile. Adam has held a number of leadership roles at eBay, including Director of eBay Express, as well as strategic and technical roles at Atlas Venture, Preview Systems and Apple. Adam holds an MBA from Harvard Business School and BS and MS degrees in Computer Science from Stanford University.

4 Responses to “What To Do in a Falling Market”

In general, would a Wealthfront risk profile of “1” be less exposed to volatility than a risk profile of “10”? In a hypothetical world where you somehow knew it would be a down market ahead, would setting the risk tolerance to “1” be wise? Hopefully that hypothetical uncovers my real question: how, if at all, does Wealthfront create an advantage during a down market for users that have selected “10” for their risk profile? I envision an algorithm that increases risk exposure when market signals look good and decreases risk exposure when signals look bad.

This type of market timing is precisely the futile exercise that leads most individual investors to underperform the market. To pull out and pull in, you not only have to predict the future twice, you also have to handle the adverse tax consequences of buying & selling shares. Thousands of people have tried to find a magic way to time the markets. The track record is not good.

Your risk tolerance should not change based on market movement. The best thing you can do in a choppy market is keep saving regularly (dollar cost averaging works for you), rebalance & harvest tax losses.

I’d suggest avoiding straw men like “you have to be right twice”. You can be right once if you are more right than wrong.

While “knowing the market is going down” might be unrealistic, it’s been proven that volatility regresses to the mean but is not stochastic. It seems perfectly reasonable when a market becomes volatile to reduce someone’s risk accordingly.

Market-wide this adjustments (including doing them in a tax-efficient manner) would be marginal and difficult for a human to execute, but isn’t that the whole point of [an automated service]? It would become an even more powerful strategy when holding individual components of the S&P 500 rather than the index, as individual stocks frequently enter periods where their volatility roams significantly from the norm.

To my knowledge, there is no known, repeatable algorithm that can generate above market returns, net of fee, net of taxes, following the market timing strategy you describe. Given the proliferation of quant hedge funds and algorithmic trading, you can be fairly sure it’s not because of lack of effort or incentive.

Direct indexing, which Wealthfront supports, takes advantage of the volatility of individual stocks within an index to generate better after-tax returns by balancing tax alpha with tracking error. More information on direct indexing here: https://www.wealthfront.com/tax-optimized-direct-indexing

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